1031 Exchange Information Pt.3

From First Tuesday

An investor must avoid actual or constructive receipt of the net sales proceeds on the sale of their property to qualify for the §1031 exemption. Thus, they may not receive their net sales proceeds themselves and in turn deposit the funds into the purchase escrow for the replacement property.

To avoid receipt of sales proceeds, a trust arrangement is set up appointing a §1031 trustee to receive and hold the net proceeds from the sale. The investor choses the trustee at the same time the documents are prepared establishing the trust, prior to closing escrow on the sale. The trustee, on receipt of the net sales proceeds, places the funds in an interest-bearing trust account. In turn, the investor uses the funds to purchase the investor’s replacement property, as well as to pay the costs of any construction to be completed prior to taking title.

As an alternative to the use of a trustee, the net sales proceeds available on closing the sale may be deposited by escrow directly to the investor’s account in the purchase escrow opened by the investor for acquisition of the replacement property. Thus, the investor funds the purchase escrow for the replacement property either directly from the sales escrow for the property the investor sold or from the §1031 trustee who holds the proceeds. The investor, by all these agreements, cannot be contractually able to demand and receive the proceeds allocated for reinvestment from the sale of their property.

If additional funds are required beyond the amount of the net sales proceeds, the investor may advance them as part of the purchase price by deposit into the escrow opened for the purchase of the replacement property.

Two types of §1031 reinvestment plans exist:

  • a fully qualified §1031 reinvestment plan;
  • a partially qualified §1031 reinvestment plan.

Under a fully qualified §1031 reinvestment plan, all the profit in the property sold or exchanged is tax exempt.

The entire cost basis in the property sold is always carried forward to the replacement property acquired in the transaction. As a result, the exempt profit on the sale of the property is shifted –– untaxed –– to the replacement property. No accounting for the profit is required.

The timing for the closing of the purchase escrow to acquire the replacement property in a §1031 reinvestment plan may be:

  • concurrent with the closing of the investor’s sales escrow, called a simultaneous closing; or
  • not more than 180 days after the closing of the sales escrow, called a delayed §1031 exchange.

Taxwise, a fully qualified §1031 reinvestment plan requires the financing of the price paid for the replacement property to replicate at a minimum the amounts of debt and equity in the property sold. Thus, to financially structure a fully qualified §1031 transaction, the price paid for the replacement property must be funded by equal or greater debt and equal or greater equity than the property sold (or exchanged).

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